978-1337099745 Chapter 12

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Chapter 12

Market Microstructure and Strategies

Outline

Stock Market Transactions

Placing an Order

Margin Trading

Short Selling

How Stock Transactions Are Executed

Floor Brokers

Market Makers

The Spread on Transaction Costs

Electronic Communication Networks (ECNs)

Program Trading

High Frequency Trading

Program Trading

Bots and Algorithms

Impact of High Frequency Trading on Stock Volatility

High Frequency Insider Trading

High Frequency Front Running

Impact of High Frequency Trading on Spreads

Regulation of Stock Trading

Circuit Breakers

Trading Halts

Taxes Imposed on Stock Transactions

Securities and Exchange Commission (SEC)

Trading International Stocks

Reduction in Transaction Costs

Reduction in Information Costs

Reduction in Exchange Rate Risk

Chapter 12: Market Microstructure and Strategies ❖ 2

Key Concepts

1. Explain how transactions are executed, from the point of the order until the trade is made.

2. Explain the development of electronic communication networks (ECNs), and how they can improve

the structure for executing transactions.

3. Explain how regulation is needed to ensure orderly and fair trading.

POINT/COUNTER-POINT:

Is a Market-maker Needed?

WHO IS CORRECT? Use the Internet or some other source search engine to learn more about this issue

and then formulate your own opinion.

Questions

1. Orders. Explain the difference between a market order and a limit order.

2. Margins. Explain how margin requirements can affect the potential return and risk from investing in

a stock. What is the maintenance margin?

3. Short Selling. Under what conditions might investors consider short selling a specific stock?

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

4. Short Selling. Describe the short selling process. Explain the short interest ratio.

Investors can engage in short selling by selling a stock that they do not own. They must borrow the

stock that they sell.

5. Stock Trading. Describe the roles of market makers.

6. ECNs. What are electronic communication networks (ECNs)?

7. SEC Structure and Role. Briefly describe the structure and role of the Securities and Exchange

Commission (SEC).

8. SEC Enforcement. Explain how the Securities and Exchange Commission attempts to prevent

violations of SEC regulations.

Chapter 12: Market Microstructure and Strategies ❖ 4

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

ANSWER: The Division of Enforcement assesses possible violations of the SEC’s regulations

and can take action against individuals or firms. An investigation can involve the

examination of securities data or transactions. When the SEC finds that action is warranted, it

may negotiate a settlement with the individuals or firms that are cited for violations, file a

case against them in federal court, or even work with law enforcement agencies if the

violations involve criminal activity.

9. Circuit Breakers. Explain how circuit breakers are used to reduce the likelihood of a large stock

market crash.

10. Trading Halts. Why are trading halts sometimes imposed on particular stocks?

Advanced Questions

11. Reg FD. What are the implications of Regulation FD?

12. Stock Exchange Transaction Costs. Explain how foreign stock exchanges have reduced transactions

costs.

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

13. Bid-Ask Spread of Penny Stocks. Your friend just told you about a penny stock he purchased,

which increased in price from $0.10 to $0.50 per share. You start investigating penny stocks, and

after conducting a large amount of research, you find a stock with a quoted price of $0.05. Upon

further investigation, you notice that the ask price for the stock is $0.08 and that the bid price is $0.01.

Discuss the possible reasons for this wide bid-ask spread.

14. Ban on Short Selling. Why did the SEC impose a temporary ban on short sales of specific stocks

in 2008? Do you think a ban on short selling is effective?

15. Dark Pools. What are dark pools? How can they help investors accumulate shares without other

investors knowing about the trades? Why are dark pools criticized by public stock exchanges?

Explain the strategy used by public stock exchanges to compete with dark pools.

16. Inside Information. Describe inside information as applied to the trading of stocks. Why is it illegal

to trade based on inside information? Describe the evidence that suggests some investors use inside

information.

Chapter 12: Market Microstructure and Strategies ❖ 6

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

ANSWER: Insiders of a publicly-traded company (such as managers or board members) sometimes

have inside information about the company, which has not yet been publicized. For example, they

might know that a company has just invented a patent that will be very valuable. It is illegal for

insiders to take positions in the stock based on their inside information, because this would give them

an unfair advantage over other investors. It is also illegal for insiders to pass the inside information on

to other investors, or for those investors to take positions in the stock based on that information.

Investors who can obtain the stock before an acquisition bid is announced can sometimes earn a

return of 30% or more in just a few weeks. In many cases, the stock price of a public company that is

targeted for an acquisition experiences an increase in stock price of 10% or more a few weeks before

the acquisition announcement. Such an abnormal increase in price for many targeted companies

suggests that some traders have inside information that the company will be acquired, and their trades

to obtain shares place upward pressure on the stock price.

17. Galleon Insider Trading Case. Explain how the Galleon case led to stronger enforcement against

insider trading.

18. Strategy of High Frequency Trading Firms Explain the strategy of high frequency trading firms.

Describe the typical time horizon of an investment that is relevant to high frequency traders, and how

that varies from other institutional investors.

19. Flash Crash of May 6, 2010 Describe the Flash Crash on May 6, 2010, and explain why it caused

so much concern to investors and regulators.

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

20. Front Running by High Frequency Traders Explain how some high frequency traders used a form

of front running to capitalize on faster access to specific markets.

20. Impact of High Frequency Trading on Spreads Explain how and why high frequency trading

affects spreads.

CRITICAL THINKING QUESTION

Regulation of Insider Trading. Some critics argue that insider trading should not be regulated, because

it allows market prices to more quickly reflect the inside information. Write a short essay that supports or

refutes this opinion.

ANSWER

Chapter 12: Market Microstructure and Strategies ❖ 8

Interpreting Financial News

Interpret the following comments made by Wall Street analysts and portfolio managers.

a. “Individual investors who purchase stock on margin might as well go to Vegas.”

b. “During a major market downturn, market makers are suddenly not available.”

forces push the stock price to a lower equilibrium price.

c. “The trading floor may become extinct due to ECNs.”

Managing In Financial Markets

Focus on Heavily Shorted Stocks. As a portfolio manager, you commonly take short positions in stocks

that have a high short interest margin. What is the advantage of focusing on these types of firms? What is

a possible disadvantage?

ANSWER:

Problems

1. Buying on Margin. Assume that Vogl stock is priced at $50 per share and pays a dividend of $1 per

share. An investor purchases the stock on margin, paying $30 per share and borrowing the remainder

from the brokerage firm at 10 percent annualized interest. If after one year, the stock is sold at a price

of $60 per share, what is the return to the investors?

ANSWER:

INV

Chapter 12: Market Microstructure and Strategies ❖ 9

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

$30

1$22$30$60$+−−

%30=

2. Buying on Margin. Assume that Duever stock is priced at $80 per share and pays a dividend of $2

per share. An investor purchases the stock on margin, paying $50 per share and borrowing the

remainder from the brokerage firm at 12 percent annualized interest. If after one year, the stock is

sold at a price of $90 per share, what is the return to the investor?

ANSWER:

INV

LOANINV DSP

R+−−

$50

2$60.33$50$90$+−−

%8.16=

3. Buying on Margin. Suppose that you buy a stock for $48 by paying $25 and borrowing the

remaining $23 from a brokerage firm at 8 percent annualized interest. The stock pays an annual

dividend of $0.80 per share, and after one year, you are able to sell it for $65. Calculate your return

on the stock. Then, calculate the return on the stock if you had used only personal funds to make the

purchase. Repeat the problem, assuming that only personal funds are used, and that you sell the stock

for $40 at the end of one year.

ANSWER:

INV

LOANINV DSP

R+−−

$25

80$.84.24$25$65$+−−

%84.63=

If only personal funds are used:

INV

LOANINV DSP

R+−−

Chapter 12: Market Microstructure and Strategies ❖ 10

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

$48

80$.0$48$65$+−−

%08.37=

If only personal funds are used, and you sell stock for $40:

4. Buying on Margin. How would the return on a stock be affected by a lower initial investment (and

higher loan amount)? Explain the relationship between the proportion of funds borrowed and the

return.

Flow of Funds Exercise

Shorting Stocks

Recall that if the economy continues to be strong, Carson Company may need to increase its production

capacity by about 50 percent over the next few years to satisfy demand. It would need financing to

expand and accommodate the increase in production. Recall that the yield curve is currently upward

sloping. Also recall that Carson is concerned about a possible slowing of the economy because of

potential Fed actions to reduce inflation. It is also considering the issuance of stock or bonds to raise

funds in the next year.

a. In some cases, a stock’s price is too high or too low because of asymmetric information,

information known by the firm but not by investors. How can Carson attempt to minimize

asymmetric information?

It could provide timely and detailed financial reports, and could use a reporting system that

allows for transparency so that its operations can be easily monitored.

b. Carson Company is concerned that if it issues stock, its stock price over time could be adversely

affected by certain institutional investors that take large short positions in a stock. When this is

happening, the stock’s price may be undervalued because of the pressure on the price caused by

the large short positions. What can Carson do to counter major short positions taken by

institutional investors if it really believes that its stock price should be higher? What is the

potential risk involved in this strategy?

Chapter 12: Market Microstructure and Strategies ❖ 11

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use

It could repurchase some of its shares in the market, which would allow it to obtain shares at a

low price. It could issue more shares later once the share price rises. Its actions would be

beneficial to its shareholders.

The risk is that Carson is wrong in its perception, which could cause it to repurchase shares

before the price declines further. In this case, its actions would not satisfy shareholders.

Solution to Integrative Problem for Part 4

Stock Market Analysis

1. Olympic stock’s future earnings should improve because it will not incur the restructuring charges in

the future. Its most recent earnings were reduced due to a one-time restructuring charge, so it could be

2. Kenner stock deserves its low P/E because its growth prospects are lower than the competition. Since

it has not kept up with technology, its growth prospects are limited. A P/E ratio implicitly captures

3. While the discount rate used to discount future cash flows generated by stocks may increase, the cash

flows should also increase. Thus, it is not clear whether stock prices would decline because of the